Why did China’s stock market plunge?

THE YEAR 2016 entered with a bang, exploding in investors’ faces.

Global stock markets saw $2.23 trillion evaporate in a week. That’s already equal to 12 percent of US public debt. The S&P 500 stock index endured its worst four days ever to start the year—and all due to the stock market dive in China.

Because the Middle Kingdom is the world’s second-biggest economy, anything that rocks its stability impacts widely around the globe.

The Shanghai composite index plunged 15 percent in the second week of January. The falls were so steep that market trading came to a halt twice.

Billionaire George Soros said that the mess reminded him of the “crisis we had in 2008,” known as the start of the Great Recession. He told Bloomberg, “I would say it amounts to a crisis.”

Cooling a hot economy

What’s behind these steep falls? As a backdrop, China’s leaders have been trying to shift the economy toward more domestic consumption. This is correct, but the economy has been disappointing in recent months.

“China’s economy is slowing as it transitions from investment and manufacturing to consumption and services,” said IMF Chief Economist Maury Obstfeld. “But the global spillovers from China’s reduced rate of growth have been much larger than we would have anticipated.”

Manufacturing and demand are weakening. In November, China’s consumer price index edged up by only 1.5 percent, and its producer price index actually fell by almost 6 percent. The latter pointed to the 45th consecutive month of dropping prices.

Popping the bubble

The origins of the plunge came years ago. After the Great Recession of 2008-2009, Beijing responded with a massive economic stimulus.

“The fact is that Chinese growth has been based in part on overinvestment,” says Robert Shapiro former Undersecretary of Commerce. “They built roads that can accommodate 20 times the traffic that they actually have.”

That resulted in a bubble in the real estate market, then in the stock market. For example valuations in technology stocks reached more than 220 times earnings. That’s way above the 150 times of the US Nasdaq market before the dotcom bubble burst.

The bubble has been popping. Steep falls occurred in June 12, July 27, and Aug. 24, 2015 and in Jan. 4 and 7, 2016. In the first one, $3.2 trillion vanished in 3 weeks—that’s equal to 10 times the size of Greece’s economy.

Last August, Beijing tried to drive up the stock market, but that failed. Authorities then tried to boost the economy by devaluing the yuan, but that involved a contradiction. Devaluation has the effect of crimping the stock market: owning stocks denominated in your weak currency becomes less appealing.

Seeing limp earnings, a gravely wounded stock market, and a weaker currency, Chinese investors are less confident.  Many have been able to move their funds abroad.

Capital in flight

Capital flight shows up in the nation’s foreign exchange reserves. China has the largest foreign exchange reserves in the world, and they fell by their biggest ever annual drop in 2015. They slumped by $512.66 billion. The amount that disappeared is six times the total reserves of the Philippines.

Most of the drop occurred in the span of August-December 2015. That speaks of large and accelerating capital outflows resulting from the surprise yuan devaluation in August and nervousness over the economy’s health.

Capital flight tends to depress the value of the yuan. That in turn prompts the central bank to support the yuan by buying it en masse, cutting its foreign exchange pile. The size of the drop indicates the massive effort by China’s central bank to stabilize the yuan after the August stock market plunge.

In 2015 the yuan lost 5 percent against the US dollar, and in the first week of 2016 it lost 1 percent.  However, investors did not expect a cut as sharp as the one they suffered in January. Investors fear a further decline of the yuan, and some analysts project a further fall of 4-8 percent against the dollar in 2016.

Circuit breakers backfire

The immediate trigger for the Jan. 7 plunge was that the central bank surprised investors by allowing the yuan to weaken much again.  That was the eighth consecutive time the yuan weakened and the biggest drop since mid-August of 2015. The slide last year spooked investors because they saw it as a signal that Chinese growth was slowing down.

Then the new “circuit breakers” kicked in. Circuit breakers are designed to limit volatility. They automatically stop trading when stocks plunge by a certain level, 7 percent in the Chinese case.

But they backfired. Investors who saw the sharp fall hurried to dump their shares before the market hit the minus 7 percent level. There was no time for a bounce. In contrast, the circuit breaker in the US involves a 20 percent fall.

The authorities suspended the use of the circuit breakers soon after. But the damage was now done.

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